People and businesses in the U.S. oftentimes receive personal loans from people they know. The loans may be from family or friends, or from a business. Sometimes the loan will be from an individual who lives outside of the U.S. and is not a U.S. citizen, or from a foreign entity. When a loan is from a foreign person or entity, there are tax withholding and reporting requirements associated with the repayment of that debt by the U.S. person, whether that U.S. person is an individual, corporation, partnership, LLC, or trust. However, in our experience, the party repaying the debt is frequently unaware of their responsibilities. In this blog, we will shed some light on the basic withholding and reporting requirements associated with the repayment of debt to a foreign person.
Let’s look at the story of Susan, who has received a loan from her friend Gianna. Susan has decided to go to graduate school and has a good friend Gianna who lives in Italy and is an Italian citizen. Gianna is very wealthy and has always supported Susan in her academic endeavors. To help her cover the cost of school, Gianna loans Susan money to cover the cost of tuition. Gianna wants to loan the money to Susan interest-free because she is doing it to help a friend rather than to make a profit. However, if the loan is interest-free, the Internal Revenue Code generally requires interest to be imputed. Therefore, to avoid having to calculate imputed interest, Gianna decides to charge 4% interest on the loan to Susan.
Susan now has an obligation to report the interest she is paying Gianna to the IRS, as well as withhold income taxes from the interest payments to Gianna. This is because Susan is a U.S. person paying interest to a foreign person. If Gianna’s business had loaned Susan the money, rather than Gianna personally, Susan would have the same reporting requirements. Even if the loan was interest- free, withholding would be required on the interest required to be imputed under the tax code.
Susan consulted her accountant and found out that generally 30% must be withheld for taxes. Tax treaties can provide for different withholding rates). Annually, she will need to file Form 1042 to report the withholdings. Susan also must keep in mind that there are strict rules on payment of the withheld tax to the U.S. Treasury. Depending on the amount withheld, the U.S. person or entity may only have a few days to remit the tax. The specific deposit requirements can be found in the instructions to Form 1042.
Depending on the circumstances, Gianna may wish to apply for a U.S. Individual Tax Identification Number (ITIN). Even if Gianna does not obtain an ITIN, Susan is still required to report and remit the taxes to the US Treasury. Susan also must provide Gianna with the annual form 1042-S to report the gross interest income Gianna received from Susan, as well as the amount of U.S. taxes withheld. The Form 1042-S, along with the transmittal Form 1042-T, must also be filed with the IRS.
Have you received a loan from a foreign person or entity? If so, we can help! Please contact us to speak with someone who is part of the International Tax Group.
By Kimberly Miller, CPA